Monday, 30 March 2009

Deflation: why the worry?

Over at the interest.co.nz Neville Bennett has been talking about deflation. He writes

Deflation is a general decline in prices, usually following a collapse of aggregate demand. There is a severe drop in spending: producers have to cut prices to find buyers. This has the effect of causing recession, high unemployment and widening financial stress.

This is one form of deflation, the bad form-1930s type deflation. But its not the only form. There is a good form of deflation, something that should be kept in mind when people start talking about it. The good kind of deflation is the result of increases in productivity. Research and development means new technology, efficiency gains, cost-cutting, price-cutting and, yes, deflation. Productivity gains mean that businesses could afford to sell their products for less since it is costing less to make them.

“Bad” deflation happens when demand shrinks; “good” deflation happens when supply expands. The price level goes down in both cases but there is only one we should be worried about. George Selgin writes,

The difference between the two sorts of deflation couldn’t be more basic. Most people grasp it without a hitch. Unfortunately, economists seem to be the exception, perhaps because of their obsession with the Great Depression and zeal to avoid repeating it. Nor has their understanding been aided by the fact that none of them has ever actually witnessed the good sort of deflation.

Yet good deflation isn’t just hypothetical. For much of the 19th century, when the gold standard prevented central banks from printing money willy-nilly, prices fell more often than they rose, and people considered that tendency to be perfectly natural. After all, technology was improving, so goods cost less to produce. Why shouldn’t prices reflect that reality? From 1873-96, for instance, prices in most gold-standard countries fell at an average rate of about 2 percent a year, while real output grew at correspondingly healthy rates of between 2 and 3 percent, thanks largely to productivity gains. That isn’t to say that there weren’t occasional crises—there were, and some involved a dose of bad deflation, driven by temporary lulls in lending and spending. But the general trend of spending was up, while the downward trend of prices remained within the bounds of underlying productivity gains and was for that reason perfectly benign: businesses could afford to sell their products for less as long as it was costing less to make them.

There are a couple of things about "bad deflation" I've never really got. One is, Why are people so worried about the possibility of even small amounts of bad deflation? There seems to be an asymmetry between the way people react to the possibility of inflation and bad deflation. Small amounts of bad deflation has people running around shouting that the sky is falling and the world is about to end, eg Neville Bennett, but if you tell people that we are going to suffer small amounts of inflation no one seems to worry. Why? Why aren't the effects of inflation and bad deflation considered to be symmetric? Also why do people worry about deflation when the one thing that any government can do is cure deflation. What government can't expand the money supply? The usual problem we have is that governments are all too keen to do so, eg Zimbabwe. Bennett writes with regard to comments made by Ben Bernanke

[...] the U.S. government has a technology, called a printing press … that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation ... the government can also reduce the value of a dollar in terms of goods and a service, which is equivalent to raising the prices in dollars of those goods and services … under a paper-money system, a determined government can always generate higher spending and inflation.

So I am left to wonder why the panic over even small amounts of bad deflation?

4 comments:

matt b
said...

Paul, isn't downwards wage rigidity a major part of the deflation problem? If firms find it hard to decrease nominal wages then faced with increasing real labour costs and declining revenues they will be forced to close up shop. Eventually things will (must) work out but nominal downwards wage rigidity takes time and considerable upset to work through.

I think this is why central bankers lose sleep over deflation.

Also, I'd have thought the good deflation is largely 'consumed' by quality improvements, and in any case largely hidden by official statistics because they are poor at handling quality changes. Although good deflation is presumably true, at least in any industry subject to Moore's Law, it is hard to see, and does not face downwards rigidities in the way labour does. Different animal, really.

There is a simple answer to your question about the asymmetry of concern. Since tax rates are not adjusted for changes in the exchange value of money, inflation rewards the government with larger tax collections. Deflation does the reverse. Since people working for the government always want and think they deserve "more", "moderate" inflation hardly seems threatening to them, especially since their defined benefit retirement payments are indexed.